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Record-high stock prices and sputtering profit growth make uneasy bedfellows. What keeps U.S. investors up at night isn't the drama in Cyprus, but whether weakening profits will unravel the rally.

There's some suspense as to what companies will report, come April. Corporate profits had rebounded strongly as central-bank support dragged the U.S. from recession. Operating profits jumped 206% in late 2009 and 31% in 2010. Since then, however, year-over-year profit growth had slowed steadily until it reached zero in 2012's third quarter, amid the uncertainty over U.S. elections and government policies. Revenue shrank 0.8% that same quarter, the first year-over-year decline of this recovery. The year ended on a brighter note, with profits rebounding 6.2% in the fourth quarter and revenue expanding 3.6%. But this sets up a cliffhanger: Is the worst behind us, or was that just a preview of more to come?

THERE'S NO QUESTION Wall Street's vocationally bullish analysts are choosing to look on the bright side. The consensus sees macro-economic fears receding, consumers spending, and the U.S. housing and jobs market slowly mending. So analysts expect Standard & Poor's 500 companies to report per-share operating profits of $25.74, $27.67, $28.56 and $29.90, respectively, over 2013's four quarters, according to Harrison. This sets up an impressive recovery in year-over-year profit growth of 1.5%, 6.2%, 10.3%, and 13.6% over the next four earnings confessionals.

Joseph Tanious, global market strategist at JPMorgan Funds, thinks earnings estimates are "overly optimistic." Many companies have already cut costs to the bone, so revenue must rise for earnings to keep expanding. Historically, revenue has kept pace with nominal global economic growth, which should average 4% to 6% over the next two years. "We expect earnings growth to be in the mid-single digits as well," Tanious writes.

Still, slower earnings growth doesn't have to derail stocks. "With fewer macro headwinds in sight and lower-yet-sustainable earnings growth ahead, multiples, rather than earnings, are likely to do the heavy lifting," Tanious says. Since the recession, corporate profits have grown faster than their valuations, so price/earnings ratios had become compressed. Today, the S&P 500 trades at less than 14 times projected profits—higher than the 12.9 times a year ago, but still below the 15-year average of 16.6. Tanious expects valuation multiples to expand about 4% a year, versus the 2% annual contraction during the period of double-digit profit growth as the U.S. first sprang from recession.

THE BOOM IN U.S. NATURAL-GAS production gives local manufacturers access to cheaper energy and helps energy-intensive businesses like chemical producers and steel makers (see "The Next Boom," Jan. 28). Less apparent is how it's also fueling demand for a host of support services, like those from water-treatment companies, environmental consultants, and testing-equipment makers.

Fracking, or hydraulic fracturing, pumps chemically treated water through rocks to extract oil and gas. Roughly 70 billion to 140 billion gallons of water are used in the 50,000 U.S. wells each year, enough to fill 150,000 Olympic-size swimming pools, and all that water must be transported, treated, recycled, or disposed of. "Some of the best investment opportunities are in the suppliers helping the industry to operate more efficiently, reducing pollution, and meeting increasingly strict environmental controls," notes Simon Gottelier of Impax Asset Management. "We could be about to witness a modern-day equivalent of selling shovels during the gold rush."

Xylem, for instance, was spun off from
ITT ITT -0.3495630461922597%ITT Corp.U.S.: NYSEUSD39.91
-0.14-0.3495630461922597%
/Date(1427835834072-0500)/
Volume (Delayed 15m)
:
483396AFTER HOURSUSD39.91
%
Volume (Delayed 15m)
:
7190
P/E Ratio
19.757425742574256Market Cap
3668579869.0033
Dividend Yield
1.1856677524429968% Rev. per Employee
282404More quote details and news »ITTinYour ValueYour ChangeShort position
(ITT) in 2011 and is known as a pump supplier, but it also monitors pollution and treats water. Xylem reported no increase in 2012 revenue over 2011's, as customers put off spending amid global fiscal worries. At $28, the shares fetch 15 times projected profits—in line with the machinery sector and a discount to water-treatment stocks. Yet Xylem has a solid cash flow, a 1.6% dividend yield, and one of the broadest arrays of water services in a fragmented, growing industry.